A typical agreement for the sale of a company will include a list of tax warranties (often a long list) and also a tax indemnity. For someone who has not previously bought or sold a company these provisions can all too often seem impenetrable.
This article aims to provide prospective buyers and sellers of companies with an overview of the purpose of these provisions and their scope. The aim is to provide some background knowledge of the topic so that buyers/sellers are in a better position to provide instructions to their advisers and ensure that their transaction proceeds smoothly and efficiently.
The article addresses the case where shares in a company are being sold. It does not consider the position where a business is sold (i.e. the assets and goodwill of a business are sold, rather than shares in a company which owns the business). With a business sale much less warranty and indemnity protection is required for a buyer due to the fact that most tax liabilities of the seller of the business will remain with the seller. A buyer of a company will take the company together with its assets and liabilities.
Readers of this article might also want to read our further the article looking at non tax warranties, which includes a general introduction to the subject of warranties.
Purpose of tax warranties and indemnities
Clearly a buyer does not want to acquire a company and then find that the company has unexpected tax liabilities. The buyer therefore wants assurances from the seller that no such liabilities exist and recompense if those assurances prove to be incorrect. In part this is about due diligence – finding out about what you are buying before you commit yourself – and in part it is about ensuring that appropriate compensation can be obtained if unexpected tax liabilities arise (liabilities which, if they had been known about, would have affected what the buyer agreed to pay).
The seller will typically give warranties which are designed to confirm that the company does not have any unexpected tax liabilities. If the seller knows that the company is, or may be, liable to tax contrary to the statement contained in a warranty, then the seller can disclose the existence of that liability in a letter addressed to the buyer (the disclosure letter). A proper disclosure of this type will mean that the buyer cannot make a claim for a breach of the warranty. The buyer will know about the liability and can consider, before completing the purchase of the company, what action to take (e.g. an adjustment to the purchase price to reflect the existence of the liability). The function of the warranties can be seen in this context to be part of the process of probing for information about the tax affairs of the company so that the buyer is well informed.
If a warranty is given and no relevant disclosure is made, and if the warranty proves to be incorrect (i.e. a tax liability which the seller represent does not exist does in fact arise) then the buyer should be able to claim for breach of warranty. The amount which can be claimed is broadly the difference between what the shares were worth without the tax liability in question and what they are worth with the liability. A buyer will also typically be obliged to take steps to mitigate any loss which would otherwise have arisen. All of this opens up room for argument about how much compensation can be claimed for a breach of a warranty. This is one of the reasons why buyers will invariably insist on there being a tax indemnity which provides a defined basis for being compensated one pound for each pound of tax liability and associated costs.
As indicated above, a typical share purchase agreement will also have a tax indemnity. The purpose of this indemnity is to specify which tax liabilities should properly be borne by the company without the buyer having recourse against the seller and which should lead to compensation for the buyer; and providing a clear basis for quantification of what amount should be paid by way of compensation. The fact that the existence of the liability in question may have been mentioned in the disclosure letter would not typically stop the buyer from claiming under the tax indemnity (unless a specific exclusion is negotiated and included within the indemnity, e.g. because the purchase price has already been adjusted to reflect the liability).
So the normal practice of having tax warranties and a tax indemnity is mainly based on:
- The warranties being there to flush out information about the tax affairs of the company before the sale goes ahead, so that the buyer can consider how best to address the existence of any problems; and
- the indemnity being there to allocate tax risks in an appropriate way between the parties and to provide the buyer with a clear basis for securing a pound for pound recovery of relevant liabilities.
Scope of tax warranties
All too often a long list of "precedent warranties" will be produced. There will be some general warranties saying that the company has paid all tax which has become due, made all tax returns and generally complied with all requirements of tax legislation; and then a long list of specific warranties saying that the company has not incurred liabilities under specific legislative provisions.
A good adviser, who has been provided with information about the company being sold and the basis on which the price has been negotiated, should be able to cut back the long list of specific warranties so that they are focused on issues which will be of interest to the buyer. This should save time and costs in the negotiation process. The latest statutory accounts of the company being sold are a very good starting point for identifying what tax issues are likely to be relevant.
There is also an argument for saying that the general warranties should be deleted or restricted. The buyer will in any event have the benefit of the tax indemnity which is expressed in general terms and which defines in a specific way how much should be paid if a relevant liability arises; whereas the general warranties could open up other arguments about how much compensation is due for a breach of the warranties. Why go to the lengths of agreeing specific indemnity provisions dealing with the quantum of liability only to have this undermined by offering the buyer an alternative basis of claiming under the warranties? Also experience suggests that the specific warranties are rather better at getting a seller to focus on what might need to be disclosed and therefore perform a better role in extracting information about the tax affairs of the company.
There will typically be some warranties designed to provide assurances that if assets were sold for the cost shown in the accounts, no tax liabilities will arise. There are circumstances in which the tax cost of an asset is lower than the accounting cost and a buyer may be concerned to know about what tax liabilities would arise if the assets were sold. That said, there will be many deals when this issue is really not of any materiality in terms of the buyer’s view of the value of the company (e.g. a service business where the company’s assets are insignificant) and so the process of negotiating these warranties and disclosing against them may be seen to be of little value. This type of contingent tax liability would typically not be covered by the tax indemnity.
Some advisers include additional warranties which are really just designed to force the seller to provide information to enable the buyer to deal with tax compliance matters after completion. However, very often these types of warranty are not of any materiality in value terms and a buyer might not thank its adviser for spending time negotiating extensive provisions of this nature. The buyer will have access to the company’s tax compliance files after completion and may be content to rely on a warranty that the company has maintained all records required for tax purposes.
The approach to the warranties may be influenced by whether the buyer has commissioned accountants to undertake an investigation of the company’s tax affairs, with the seller providing full access to the tax papers for this purpose. In such case it may be that much of the information gathering has been done and the need to use warranties to flush out information is therefore reduced.
Scope and form of tax indemnities/covenant
What is in effect a tax indemnity will typically be referred to as a tax covenant. The old approach was to have an indemnity in favour of the company being sold for tax defined tax liabilities. However a payment in settlement of a claim under the tax indemnity can in these circumstances be subject to tax. The way this problem is addressed is for the seller to covenant with the buyer to pay to the buyer an amount equal to any relevant tax liabilities which might be incurred by the company being sold. A payment to the buyer under this tax covenant can usually be treated as an adjustment of the purchase price for the shares, avoiding the tax problem referred to above.
The basic scope of the tax covenant will be for all tax liabilities relating to the period up to completion of the sale. The key limitations on this scope will depend on the basis on which the deal is taking place. The two most commonly encountered pricing structures are:
- The buyer effectively buys the company as at the date to which the last set of statutory accounts was prepared (the accounts date). In this type of deal the profits or losses of the business from the accounts date onwards accrue for the account of the buyer. In this case the buyer’s liability under the tax covenant will not extend to tax liabilities which are provided for in the statutory accounts (the buyer will be aware of these liabilities in agreeing the price) or to tax arising in the ordinary course of the company’s business after the accounts date;
- The sale agreement provides for completion accounts to be prepared and the purchase price is adjusted after completion to reflect the figures in the completion accounts. For example, the price initially payable might be based on an assumption that net assets of the company at completion are not less than £x; and if the net assets figure in the completion accounts is less than £x a pound for pound adjustment might be made. If, in such a case, the net assets are arrived at after taking into account a provision for tax for the period up to completion the scope of the tax covenant would essentially be for all tax liabilities up to completion, other than those provided for in the completion accounts.
Some other provisions often included in the tax covenant are as follows:
- The company being sold may be exposed to specific liabilities not covered by the general scope described above. For example, employees of the company may have share options over shares in the company or, in the case of a company being sold out of a group, over shares in the parent company of the selling group. These options might become exercisable immediately after completion, giving rise to PAYE liabilities for the employer company. A specific indemnity for these liabilities may be required;
- Specific provisions will quantify the amount to be paid and the time at which the seller must make payment;
- The subject of losses and tax reliefs may be addressed. Sometimes the purchase price will ascribe value to tax losses assumed to be available in the company, in which case specific provisions will need to address what should happen if the assumption should prove to be incorrect. Sometimes no such assumption has been made, but there remains the possibility that the value of certain tax reliefs or losses may be reflected in the accounts on which the deal is based. Typical legal drafting provides for the buyer to have a claim under the tax covenant if such reliefs or losses prove not to be available. This is an area which can be heavily negotiated between lawyers. Rather than letting this get out of hand, it is sensible to focus on the materiality of the issue in the context of a particular deal – e.g. if the price is based, at least in part, on the value of the net assets of the company, then it might be appropriate to have a right to indemnification if the value of a tax relief which is reflected in the accounts proves not to be available. If the price has nothing to do with net asset values, this may not be appropriate;
- If the company is a subsidiary being sold out of a group specific provisions will often be required to address certain tax group issues – e.g. the consequences of a VAT group being in place to ensure that VAT liabilities are borne by the appropriate company; or the rights of the selling group to require pre-completion losses of the company being sold to be surrendered to it (if those losses are not being paid for); or to require that losses in the selling group are surrendered to the company being sold to eliminate tax liabilities which would otherwise have given rise to a liability under the tax covenant;
- The seller will require additional limitations on its liability to be included; e.g. to prevent double recovery under the covenant and the warranties; and to exclude tax liabilities which are generated by action taken by the buyer after completion. Some of the limitations applying to non-tax warranties may also extend to the tax covenant and the tax warranties – e.g. a limit on total claims to an amount equal to the purchase price;
- A time limitation will typically be included. Very often this prevents claims being made more than six or seven years after completion, reflecting the normal limitation period for HM Revenue & Customs (HMRC) to make recoveries. Buyers sometimes try to provide for the time limitation to extend further, in circumstances where HMRC has a right to extend the normal period. From the seller’s perspective it is preferable to have a definitive cut off date so that a time comes when it is known that there can be no further contingent liabilities;
- If a potential tax liability arises which is within the scope of the tax covenant the seller will wish to have provisions which enable it to have some control over how the case is argued with HMRC;
- Provisions will often be included to regulate how tax returns and the process of agreeing those returns with HMRC relating to the period up to completion are dealt with (bearing in mind that both parties have an interest in what flows from those returns);
- The seller may not want the buyer to assign its rights to make tax claims to someone else (who has not been a party to the negotiations) after completion. If so, a specific prohibition on assignment must be included;
- If there is more than one seller the sale agreement will often provide that liability under the tax covenant and the warranties will be joint and several, meaning that the buyer can claim the whole or any part of the amount due from any of the sellers. In such a case the sellers may wish to have their own separate agreement regulating how they should each contribute to any claims (e.g. proportionate to the shareholdings being sold).
Other points will be covered in the tax covenant with a view to trying to ensure a fair means of apportioning tax risks between the parties.
Roles of advisers and principals
The lawyers acting for the buyer and seller will lead the process of drafting and negotiating the tax warranties and indemnity, referring to their clients for instructions as necessary.
Some clients like to have a more "hands on" role in this process than others. It is clearly important that the parties understand what they will be signing; equally a good adviser with sufficient experience of deals of this nature can take much of the burden off a client, using his or her practical experience to ensure a fair and reasonable position is reached. Many larger law firms have tax specialists who should well equipped to ensure tax provisions are appropriate and to explain to their client what specific warranties mean and to prepare/review the disclosures. Law firms without specialist tax expertise will often rely more on the client’s accountant to help with this process.
The seller will need to consider how best to deal with the disclosure process. Whoever has dealt with the company’s tax compliance affairs will be best placed to take the leading role on this. If the company has engaged accountants to deal with the company’s corporation tax returns, then those accountants will be best placed to lead much of the disclosure process. In such a case, it is often the case that the accountants do not deal with the PAYE and VAT compliance and someone at the company may need to assist with this. Relevant factual information will be provided to the seller’s lawyers who can then ensure (with specialist tax input) that the wording of any disclosure is appropriate.
Prospective sellers will appreciate that ensuring that the tax affairs of the company are in good order and up to date before they get into a sale process should help the process run smoothly. Undertaking risky and aggressive tax planning, or adopting a less than thorough approach to tax compliance matters, can result in more protracted enquiries and negotiations. The buyer may also require specific indemnities to cover particular tax issues which are identified and retentions from the purchase price to cover potential liabilities.
Many deals will start with a heads of terms document or a term sheet recording the main terms of the deal. A view has to be taken as to how much effort goes into negotiating more detail for this document, rather than just setting out the key commercial terms and dealing with the detailed negotiations later when lawyers are more fully engaged. However, it will be worth bearing in mind some of the points made above (e.g. as to the scope of the tax covenant) in case any points can be recorded in the heads of terms in order to avoid arguments at a later stage.
Providing the lawyers with as much context for the legal negotiations as possible (including factual information about the company being sold and details of how the purchase price has been arrived at) should help them work more efficiently. That said, much still depends on all parties who are involved taking a reasonable approach. If both principals agree to manage the legal process in the same way, this can only help.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.